Foreign Aid, Wage Inequality, and Welfare for a Small Open Economy with Tourism

Abstract

While the welfare effect of foreign aid has been extensively analyzed, the impact on the distribution of income has received less attention. At the same time, there has been recent work on tourism where it is complementary to aid in improving welfare. By combining these two strands, this paper concentrates on wage inequality in developing countries. We find that an increase in aid in the form of tied aid can lower the relative price of nontraded goods. The rent extracted from tourists declines, reducing welfare of domestic residents. In addition, the fall in the nontradable price can widen the wage inequality between skilled and unskilled workers. Thus, increased foreign aid may have detrimental effects on national welfare and the distribution of income. Rising wage inequality is confirmed by numerical simulations. Copyright � 2010 Blackwell Publishing Ltd.

Reinventing Foreign Aid for Inclusive and Sustainable Development: Kuznets, Piketty and the Great Policy Reversal

“…There is a substantial bulk of the literature consistent with the positive role of foreign aid in mitigating income inequality (Tezanos et al ., , p. 153). Although another strand of the literature has also substantially documented the positive role of aid in skewing income distribution (Klitgaard, ; Bayart, ; Boone, ; Svensson, , ; Calderon et al ., ; Hoodler, ; Layton and Fuller, ; Chong et al ., , p. 89; Herzer and Nunnenkamp, ), some authors think the unexpected nexus is because of tied aid (Chao et al ., , p. 454) or the absence of an aggregate effect is because of high inequality (Tezanos et al ., , p. 153). Even countries with high governance and democratization are also associated with high inequality…”

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“…The domestic residents' demand for traded and non-traded goods, D T and D N , under a cash-in-advance constraint are as follows: Copeland (1991) and Hazari and Sgro (2004) examine the static effects of inbound tourism on trade and welfare in barter economies. Also see Chesney and Hazari (2003), Nowak et al (2003), Chao et al (2010a) and Chao et al (2010b) for related studies on tourism and economies. 3 To consider the short-run and long-run effects of tourism on foreign reserves, the fixed exchange rate system is needed because equilibrium foreign reserves are zero in the flexible rate system.…”

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“…Bussolo and Niimi (2006) analyzed one proposed regional trading agreement. There is evidence from Chao et al (2010) that efforts to help poor countries such as foreign aid can increase inequality.…”